If you buy into the idea of a business cycle, the economy is a lot like a forest that grows, prospers, becomes large and then, with the right conditions, usually a drought or a lightning strike, is cleansed by a great fire — a recession. And then the cycle starts again anew.
The American people tend to measure how bad recessions are based on the unemployment rate. In modern history, the Great Depression was the worst, where unemployment hit 25 percent. The 1982 and 2008-2009 Great Recession come after, where unemployment reached 10.8 percent and 10 percent, respectively. Whereas, the 1991 recession was shallower by comparison and saw joblessness reach 7.8 percent at its peak in June 1992. The dotcom bust of the early 2000s was even more moderate, with unemployment peaking at 6.3 percent by June 2003.
The difference between a moderate or steep recession, at today’s labor market levels, is millions of jobs. If unemployment were to rise to 6.3 percent, that would mean 4.3 million jobs were lost above today’s levels. At the steep end, at 10.8 percent, that would mean 11.6 million jobs were lost.
That’s quite a difference. Perhaps a better way of looking at it is that, with good planning — by clearing out the underbrush — in the next recession whenever it happens 7 million jobs can be saved for having never been lost in the first place.
Which brings us to today. We’re not in recession. The economy is still growing at 2 percent in the second quarter and unemployment is near 50-year lows at 3.7 percent. Wages and personal compensation have accelerated during the Trump administration, too, although July’s numbers were not great. That’s all great news and speaks to the current strength of the economy.
But growth has slowed down temporarily, and certain warning signs in the bond market are sounding off, for example the 10-year, 2-year inversion, that if they persist for weeks and months increase the likelihood of a recession perhaps as soon as 2020 or 2021.
So, what can be done to strengthen the economy now so that if and when a recession does hit eventually, we’re prepared and it’s as soft a landing as possible?
Arguably, with the tax cuts, deregulation and better trade deals being worked out, the Trump administration is already ahead of the curve. On the other hand, the 1982 recession came right after the Reagan tax cuts, which were the largest in history. So they did not stop the downturn, although they surely helped to foster the robust recovery that followed.
This is where politics usually intrudes and the psychology of the economy takes over. Automatically, the incumbent party, in this case President Donald Trump and Republicans, don’t want to talk about a potential recession because it’s bad for business and don’t want to be accused of talking down the economy. Whereas the opposition party, Democrats, will want to play up the potential of a recession because if one does strike, they believe it would benefit them politically.
In 2007 and 2008, the Bush administration was caught flat-footed to address the imminent recession that turned out to be a big one. How’d that turn out? What usually takes place at this point in the cycle is a mixture of denial and alarmism, neither of which can be helpful because it does not tend to focus on real problem areas.
That is one reason we have — or are supposed to have — an apolitical central bank, the Federal Reserve, to soften the business cycle and conduct monetary policy, buy and sell bonds and set the federal funds rate. Now, one can argue about whether the Fed should have such a role—markets might do a better job — but right now under the law, it’s their job to set the low rate.
And right now, there are arguments to be made that the federal funds rate is too high—it has been inverted with the 10-year treasury since May. Everyone seems to agree, President Trump has been calling for lower rates since last October. And the Fed finally came around to that view, albeit nine months later at its July meeting, and finally cut the policy rate 0.25 percent after it began hiking in earnest after the 2016 election.
That’s probably not enough, and so now markets are expecting more rate cuts beginning in September. To cure its own inversion with the 10-year treasury, it would have to cut by at least 0.65 percent based on the latest reading. In theory, if it cut a full percentage point — something Trump has urged — it might safely cure its own inversion, restore confidence that the Fed is not asleep at the wheel. The add-on effect might be giving a boost to equities and cause a flight out of bonds, forestalling recessionary forces. That might cure the other inversions for some time, perhaps kicking the next recession down the road a couple of years.
In 1998, the federal funds rate and the 10-year treasury inverted and the Fed acted quickly to cure the inversion, and then it was not seen again until 2000, about a year before the recession.
The Fed’s next meetings are Sept. 17-18 and Oct. 29-30, so we’ll know very soon where they choose to go. My thinking is to expect rate cuts here on forward, but the question is by how large. Anything less than a 0.50 percent cut at the next meeting, which may not even be enough, will probably have markets continuing in some degree of turmoil.
As for President Trump, he remains committed to getting better trade deals, and is using tariffs and sanctions to force China to the table to deal with currency manipulation, intellectual property and trade barriers to U.S. exports. Taking that as a given, he might consider accelerating his timeline of escalation including the use of the broader economic sanctions to force a resolution to the current impasse sooner rather than later.
Time is a major factor with the election right around the corner. There is no guarantee Trump will be around in 2021 to see it through. With global economic conditions softening, China appears to be betting it can wait Trump out. That necessarily compresses the timeline — that was Beijing’s choice, not Trump’s, they had a deal in May and Chinese President Xi Jinping balked — leaving the only apparent solution to make the economic pain so bad they capitulate and come to the table.
If Beijing does not want to deal, it may be best to rip off the band-aid as quickly as possible. That might not please markets either, but the uncertainty right now might be the worst of it. Sanctions would make matters crystal clear.
In the meantime, Congress has the U.S.-Mexico-Canada Agreement on the table and it’s time to act on it to shore up alternatives to China. Americans for Limited Government President Rick Manning emphasized the importance in a statement today, “As the decoupling with China begins, President Trump is ahead of the curve in securing trade deals with Japan and also Canada and Mexico as supply chains are moved away from China. There’s nothing that China produces that cannot be produced elsewhere. The USMCA is about to be submitted to Congress and is ready to be adopted. It will be a boon for U.S. exporters including agriculture, and addresses labor conditions in Mexico. Plus the currency provisions against competitive devaluation will set a gold standard in terms of shaping future trade deals. It is important that Congress act now and not get caught flat-footed. After more than 25 years of complaining about NAFTA, it’s finally time to do something about it by supporting the new USMCA agreement.”
For their part, President Trump and Congress might consider a temporary payroll tax cut to boost consumer spending or to help households pay down some debt. That can certainly help ahead of a potential downturn, even if it’s still a couple of years away. Although, the President has ruled it out for the time being. There also has been talk of indexing capital gains taxes to inflation.
One thing Congress and the President seem to share in common is a desire to address the nation’s infrastructure needs both for transportation and delivering high-tech infrastructure. If so, and you take it as a given, Congressional Republicans might do better to go with a Trump version of such a plan now, which includes private financing, rather than waiting to see if Democrats win the next election. If Democrats win, the GOP will probably like their plan even less, as it will lean on government more. Such a move now ahead of the elections might generate confidence that Washington, D.C. can get big things done, with upside potential.
Then there are the trouble spots that are likely to be worsened when the next recession eventually does come along. The dollar is too strong versus other currencies leading to tepid growth and almost no inflation, and even if it temporarily weakens in the downturn, its relative strength versus trade partners will not help foster a recovery.
Also, U.S. corporate debt is close to $10 trillion, multiemployer pensions are still an unresolved matter as Congress considers what to do and the current homelessness crisis, fueled by China’s opium war on the U.S., can always get worse.
Of those, corporate debt might be best addressed simply with the Fed’s lowering of interest rates, which can loosen lending conditions and make it easier to refinance. But no bailouts. Defaults are a necessary part of creative destruction. Competitors will pick up the pieces later by acquiring assets on the cheap. Resolution authorities under Dodd-Frank might be tested, and they allegedly mitigated the need for anymore bailouts. I’m willing to take that on faith, but we wouldn’t support corporate bond bailouts for any reason even if there was no resolution process baked into the law.
Congress is considering proposals to shore up the union pensions that they would do well to finish before the next recession and taking into account the likely effects of any downturn. This could have been addressed last year but alas the Republican Congress could not get it done before the end of the session. It can be addressed now while there’s still a bipartisan framework to accomplish it. The price tag will probably go up later, and so will the size of the haircuts everyone involved will have to take. Everyone’s going to have to give a little, including the unions, either way. This is one where time is an essential factor.
And then with housing, the Trump administration might consider going bold and take a page from Eastern Europe circa the end of the Soviet Union, when public housing was privatized, creating housing markets overnight by transferring title of public housing units to tenants. Similarly, excess housing stock owned by Fannie Mae, Freddie Mac and the FHA could be turned over to municipalities to serve as housing for the working poor or those at risk for becoming homeless. To mitigate the potential of foreclosures if and when unemployment rises, Congress and the Trump administration could also consider a certain amount of principal forgiveness for mortgages held by the GSEs. That would reduce monthly payments and free up household cash, a key concern in softening the blow of a potential downturn.
Finally, on the strong dollar, President Trump would do well to coordinate with key U.S. allies to work on an international monetary accord to avert competitive devaluations. Right now, the entire world stockpiles U.S. treasuries and other dollar-denominated assets like they are gold. It’s one of the key reasons interest rates are so low and going lower. They might even go negative in the next recession, but that should not be viewed as a positive indicator or a panacea. Just as high interest rates signal too much inflation, low or negative rates signal the dreaded deflation that wreaked havoc in the Great Depression and Recession. Just ask Japan and Germany how negative rates are helping to boost their growth rates (hint: they’re not).
Then there’s always do nothing as an option, which is not unfounded. Oftentimes, the federal government will end up doing the wrong things, and usually too late to make much of a difference in averting an economic downturn. I don’t think it’s too late yet, and there are things such as the Fed keeping its interest rate too high right now that do need to be addressed immediately.
Like good forest management, and clearing out the underbrush, much can be done ahead of time to lessen the negative impacts of the next recession. The less bad it is, the less revenues will take a hit, and the less bad the budget deficit will be. Hopefully we won’t have one at all but it’s always best to plan ahead. Even with a presidential election year right around the corner, rather than the typical pattern of denial and alarmism, with the flashing red lights from the bond market, the American people would appreciate their leaders including President Trump and Congress get ahead of the curve for a change and show us how it’s done. Just this once.
Robert Romano is the Vice President of Public Policy at Americans for Limited Government.
